Given where we are in the year, prices are unusually high. And if
trends hold, then the national average will be well over the $4
freakout point sometime this summer.

But whenever the discussion turns to gas and oil, logic tends to
die, and people start coming up with all kinds of bizarre
explanations for what's going on -- explanations such as the
Bernanke's money printing, Obama's domestic energy policy,
Obama's foreign policy, speculators, price gougers, and
so on.

So we thought it would be a good time to just clear up some
misconceptions, and explain what's really driving the price.

Of course, you can't start a discussion about gasoline without
talking about oil. So let's begin there.

You may have heard that the price of a barrel of oil is around
$109, but actually that's the US domestic West Texas Intermediate
price of oil. A better international benchmark is probably Brent
Crude, and that's now well over $120/barrel, having surged all
year.

FRED

So what explains the sudden rise in oil? Well, basically, good
old supply and demand.

In a note that went out this week, BarCap's Miswin Mahesh and
Amrita Sen explain how the oil picture seems to have changed
dramatically in just the first several weeks of the year:

At the start of the year, the average call on OPEC crude for Q1
was 29.7 mb/d, while OPEC production was comfortably higher at 31
mb/d. A seriously warm winter and a series of extremely weak OECD
demand indications paved for further downgrades to demand and
demand expectations. This should have then allowed for the almost
barren inventories to fill and provide somewhat of a cushion to
tightening fundamentals in the second half of the year.

Yet, the year so far has evolved differently in a significant
way. Despite what looked like a rather well-supplied prompt
market, the weakness in time spreads has abated. While the spate
of cold weather in Europe has helped to normalise balances, in
our view, it has really been the uptick in Asian oil
demand that has helped to absorb the extra OPEC volumes.
Indeed, we believe that Asian and FSU oil
demand are growing at a faster pace than markets are currently
pricing in. While US and European demand remains very weak, and
as a result, the overall state of global oil demand may be
nothing to write home about, equally, it is not declining,
contrary to market expectations.

Further, while OPEC may be producing close to 31 mb/d, the high
level of supply losses on the non-OPEC front have intensified.
Output from Sudan, Syria and Yemen at a combined total of almost
1.2 mb/d has been compromised, while non-geopolitically based
outages in the form of technical issues are also on the rise. As
a result, while the extra OPEC volumes would have otherwise been
a surplus at the margin, it has now become a necessity to simply
maintain the status quo.

They go on to make a key observation about the global economy
that you should probably remember for years to come ...

The problem with judging
the global pace of oil demand growth is that the epicentre of
that growth has most definitely moved away from the US to Asia,
and China in particular. Yet, due to the lack of prompt
alternatives, the more readily available oil data from the US is
still used as a global guide to the health of the oil
markets.

A series of charts back up their point.

Global demand growth has, in fact, turned positive year-on-year.

Barclays

Non-OPEC output has been collapsing:

Barclays Capital

Even in non-geopolitical hotspots, a host of technical issues in
Australia, Canada, Norway, and the U.K. have hit supply all at
the same time.

Meanwhile, OPEC producers have very little slack these days.

BarCap

Finally, one last chart, inventories have become increasingly
scarce.

Barclays Capital

So you should get the idea, but here are the key points from
above:

Demand is booming in Asia and the Former Soviet Union,
offsetting mediocre demand in the U.S. and Europe.

Inventories are low.

Supply has been hit in several countries due to geopolitical
and technical problems.

To some extent, all of the above has been a modest surprise
to the market, at least as compared to official predictions.

Add in some kind of "fear" premium due to a possible war with
Iran, and it's just not that hard to see why the price of a
barrel of oil has surged like this.

Now it's worth taking a moment to emphasize that this is an
oil story, and not just a mere commodity story.

So for example, here's a look at copper prices. They've been up
in 2012, but are still nowhere near where they were in the middle
of last year.

This would strongly suggest that frequently-heard explanations
for the oil rally like "currency debasement" or "inflation" or
"the Fed" or "the weak dollar" or "speculators" just don't fly,
since you'd expect to see a similar flight-to-real-assets in
places that aren't oil. Alas, you're not seeing that. Again, this
is an oil story.

Oil is just part of it though: There's also the matter of turning
oil into gasoline.

It turns out, the U.S. is experiencing a bottleneck at the oil
refining stage.

On February 23,
Bloomberg reported that the U.S. had lost 5 percent of its
refining capacity in just the last 3 months.

Over the past year, refineries have faced a classic margin
squeeze. Prices for Brent crude have gone up, but demand for
gasoline in the U.S. is at a 15-year low. That means refineries
haven’t been able to pass on the higher prices to their
customers.

As a result, companies have chosen to shut down a handful of
large refineries rather than continue to lose money on them.
Since December, the U.S. has lost about 4 percent of its refining
capacity, says Fadel Gheit, a senior oil and gas analyst for
Oppenheimer. That month, two large refineries outside
Philadelphia shut down:
Sunoco’s plant in Marcus Hook, Pa., and a ConocoPhillips plant in nearby Trainer, Pa.
Together they accounted for about 20 percent of all gasoline
produced in the Northeast.

The article goes on to note the bifurcation of the U.S. refining
industry: East coast refineries that have been refining Brent
Crude have gotten squeezed, and have been taken offline, whereas
the Midwestern refineries that process cheaper, WTI oil have done
okay.

That explains this map, which shows the dramatic divergence
between the price of gasoline on the coasts, and the price in the
Midwest.

APC

For some more perspective on this issue, check out this chart
from Citi's Steven C. Wieting:

Citi

The U.S. refining industry is essentially dealing with a
Katrina-like hit to capacity utilization ... this time all thanks
to economics.

So there are two stories going on simultaneously.

There's the oil story, with its robust global demand and supply
disruptions, and the U.S. domestic gasoline story, which is
related to a bottleneck in refining capacity.

Now, times when prices at the pump are rising often make for a
good time to scold politicians for not expanding our domestic
energy capacity, but in reality, this attack couldn't be more
misguided. Despite some high-profile cases, like the decision to
not-approve the Keystone pipeline, the truth is that the U.S.
domestic energy renaissance is big and shocking, and very few
people saw it coming.

Here's an interesting comment from a Goldman energy report from
the 22nd:

The short answer is a firm “no.” To be sure, we are quite
optimistic on the growth potential from key unconventional oil
plays like the Bakken (ND), Eagle Ford (TX), Permian Basin (TX), and California
and the positive impact on overall US liquids supply.
We now forecast US liquids
production (crude oil plus natural gas liquids [NGLs]) will grow
on average at 4% per year rate through
2015—asrecently as 2-3 years ago,
we would have forecast 2%-3% per year secular declines in overall
US liquids production.

Think about that: If the forecast has gone from a 2-3
percent/year decline in production to an expectation of A 4
percent/year increase in production, it's impossible to say that
the present conditions of the U.S. energy industry are somehow
net bullish for the price of oil. If anything, the U.S. story is
mitigating the oil price rise.

Meanwhile, employment in oil and gas extraction is hitting levels
not seen since the early '90s.